Pictured: Mario Draghi, President of the European Central Bank (ECB). Source: The Economist
The Euro crisis has been going on since the stock market crash and the bankruptcy of the investment bank, Lehman Brothers.ltd. Fast forward five years, and the euro is still in quite a big mess. Majority of the large economies in the euro now have painfully serious budget deficits. On May 26th, Spain's fourth-largest bank requested a €19 billion ($24 billion) bail-out from the state. The famous 5 euro countries, dubbed as 'PIIGS' for their terribly high deficits and underwhelming economies, are in constant danger going into default. What happens when a country defaults? There are no set-in-stone definition or conditions when a country defaults, but whatever it is, it certainly would not be very pleasurable. Most likely, the countries will have to engage in further austerity programs, restructure of debt, only to name a few; the IMF most probably will have a plethora of tough measures ready when countries announce their bankruptcy.
Creative people may have to think up of another word as the downward spiral recession in the eurozone are going to affect many more countries. Please take a look at the image below (click image to view full size).
This chart may have been on the web for a good while (Greece's current credit rating is CCC, another saying of 'mediocre'), but it is a very good representation of how badly Europe is doing in terms of their economic situation. Out of 14 countries at the risk of bankruptcy, 7 out of 14, 50%, are European countries. In my opinion, this is hardly surprising because I have always considered the amount of social welfare among European countries a major factor for the lack of government funds. Although the income taxes are astonishingly high, for example PSG footballer Zlatan Ibrahimovic's 75% income tax on his wealthy annual 13 million euro salary, the transfer payments to low income people in the form of unemployment benefits, and pensions is hurting the government's purse. Transfer payments is where the government uses its tax revenues to redistribute income in the market system to different groups in the economy; the transfer of money is made without an equivalent exchange of goods or services. In 2011, the official government spending statistics show that the UK government spent a total of 232.9 billion pounds, or 33% of GDP on welfare and pensions combined.
Furthermore, recent talks about cutting down public spending is undermined if we look at the chart below.
From 1985 to the predicted level of spending in 2014, the total spending by the government has nearly quadrupled in the last two and-a-half decades. There are numerous economic factors for this increase. Firstly, arguably the basis for economics, the idea of limited resources coupled with unlimited wants for economic growth, hence spending keeps on increasing. The second factor could be the increase in population. The improvement in healthcare, technology, income levels etc., is a universal reason for the continual increase in the world population. While this represents development of the human race, more people ultimately leads to more resources needed to be used by the government to meet the needs of society. The third factor could be the unemployment trap. Due to high unemployment benefits in European countries, employed people working in relatively low paid jobs that earn less than receiving benefits from the government may choose not to work. These are all probable reasons for the high budget-deficit.
We really must get back to the main story. Last week, at a investment conference in London, Mario Draghi, the president of the European Central Bank (ECB), has announced that they will start buying government bonds in the coming weeks when vulnerable countries present their balance of payments and their structural reform policies. What does buying government bonds mean? Well for starters, it is a source of funds for the government to pay back its debtors. However, the money is only a short term solution to the problem; what we must all understand is that long term problems require long term solutions. When reporters and investors questioned his intentions, he replied, with a rather cool demeanor, "the ECB is ready to do whatever it takes to preserve the euro - and believe me, it will be enough." Plainly, the markets do not believe that Mr Draghi has done enough to quell the fear that the euro may break up. Certainly, Mr Draghi was defiant and had no regrets blurting out the above quote during the London investors conference. Well, I have my suspicions on this one; his response was not the immediate or massive response I would expect after setting up the conference.
If Mr Draghi is adamant on his view that the euro can be saved by the ECB alone, how long can the countries continue to rely on the ECB? My view is that vulnerable countries with large budget deficits are basically eating off the ECB's money supply, the ECB does not have unlimited money to drag this out forever. Of course, it has always been worrying to see how rashly the ECB acts by giving seemingly unlimited amounts of money to support the euro states. The ECB certainly cannot afford to turn a blind eye to this fragile matter, it needs to balance out its power/authority; between printing vast amounts of money and maintaining price stability, between the interests of creditor and debtor states and maintaining market pressure on countries to reform and preventing them from being pushed into insolvency.
What if eventually the ECB runs out of money? That is what Mario Draghi will be trying to avoid as he needs to set effective borrowing policies and get countries to meet those goals. If the euro countries are going to get anywhere, they have to implement structural reforms to the faltering economy. As with structural unemployment, structural reforms indicate that the country's economy is unable to sustain itself with the level of deficits, and have to implement policies and conditions to obtain loans from the International Monetary Fund (IMF) or lower interest rates for their loans. These conditions are usually austerity measures. Certainly, austerity measures, in theory, will enable the government to cut-back on spending in order to pay their deficits. For example, in order to secure the 130 billion euro bailout package, Geece accepted its 5th austerity package. The following conditions of the 5th package are summarized below that are supplemented to the other 4 packages:
22% reduction in minimum wage
150,000 jobs cut from state sector by 2015
Pension cuts worth 300 million euros ($370 million USD) this year
Deregulation of workers laws and reducing trade union power
Health and Defence spending cuts
Naturally, the citizens would not be happy by the decrease in welfare, even if they are much better off than most countries outside of Europe. And their response? Social unrest, protests and riots will take place if the austerity measures are too tough. On the 5th of February, after the 5th austerity package was implemented in Greece, violent protests raged the streets of Athens that involved 100,000 people.
From this, we can summarize the course of actions currently taking place in euro countries and the ECB:
1. The euro country (not specified as all of them are in trouble) is nearing the deadline to pay debtors, but have an insufficient supply of money, and hence, requires a bail-out from the ECB.
2. The ECB will be glad to pay the sum of money, but not for free. So the ECB will implement conditions to the country before the bail-out money can be given to them. Structural reforms and austerity measures to the country takes place next.
3. After the country implements the austerity measures, the euro citizens, who are so well taken care of by the government by relative standards for so long, suddenly being required to give up their "luxury" lifestyles would obviously be angry. Social unrest will follow with protests and riots.
The above illustration is a testament to American economist, William Easterly's view that deft-relief would cause detrimental effects to the economies and societies concerned due to diminishing productivity and undesirable austerity measures. In theory, debt-relief is supposed to lift the country out of recession and increase output, however, debt-relief is a step backwards, rather than forwards! The main issue is that theories may not necessarily work in the real world when people are guided by incentives. Its very similar to why did economists create the theory of veblen goods and giffen goods? Because they were obviously baffled by the abnormal spending patterns that did not obey the law of demand and supply, the fundamentals of economics. Mr Draghi is a very smart man; he is playing the game correctly using economic theories to back up his strategies, but the single flaw of the social science is in the social-side of it after all...humans!
So how long can the ECB drag it out? That will only depend on whether the citizens in Europe (except for Germans) will be willing to suffer in the present, in order for their respective countries to regain economic power.
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